Using Options in Lieu of Stops: A Corn Market Example
By Michael Florez ISSUE 311 | DEC 2004
One of the more irritating episodes a trader can experience is getting stopped out of a trade just before that large move you were looking for occurs. It feels almost as if the market was out to get you. If this has happened to you, it gets you angry and in your mind, enforces the idea that stops shouldn't be used. The mental process usually takes the form of, "I won't have my stop sitting in the market; instead I will use a mental stop." Invariably, the stop price is reached and no stop is ever placed, resulting in a loss much greater than what was intended. This creates psychological damage. The very thing you fear the most, a loss, becomes even larger because of the avoidance of placing the stop. This fear can freeze you as a trader, making trading a more difficult task.
There is a way to overcome this difficulty, which solves both problems at the same time: the fear of placing a stop, and the possible avoidance of large losses. Here’s an example of this at work, using the corn market.
There has been some market talk lately of a potential bottom in corn, as prices have dropped to two-year lows. Because of high energy prices, there is hope of an increase in domestic corn usage tied to a higher production of ethanol, because ethanol is a gasoline substitute. If you are a longer-term trader, you could buy March corn futures at about $2.10 a bushel and also buy a March $2.10 put for 8 cents, or $400. What this now does, if markets were entered at these exact prices, is fix your entire risk to $400 at expiration of options (2/18/05) plus brokerage fees. It also gives you virtually unlimited upside potential if corn moves higher.
Again, these are hypothetical examples, but if the market went up to $2.50, your gain would be $2,000 on the futures side, minus any loss on the option ($2.50-$2.10 = 40 X $50 = $2,000 - loss on option). Until expiration, it is not possible to predict the value of the option. However, if purchased at $400, then that would be the maximum amount that would be subtracted from the $2,000 gain. If, on the other hand, corn dropped to $1.50, you would have a loss of $3,000 ($50 X 60=$3,000) on the futures contract, but you would have a gain of $2,600 on the option ($2.10-$1.50=60 X $50= $3,000-400 for the option=$2,600). It doesn’t matter how low the market drops; your option acts as a stop. Your maximum exposure to loss is $400 plus brokerage fees.
The above example shows the math, but it doesn't reveal the emotional swings you take as a trader. Emotion is the most important obstacle you must overcome to ultimately have success investing. Imagine your feeling if you had bought corn at $2.10 and it's now at $1.75. Does it bring back memories? It is hard to put a price on stress, but the $400 option, bought as protection, can become a welcome addition to any trading strategy. This method can be used in any market, but getting the right option requires a bit of market savvy.
What are the advantages of this approach? Instead of using a stop, you can buy protection using an option at the same time you enter the market with a futures contract. This strategy will give you a defined risk up front. You will always know what your stake is; short-term gyrations in the market become insignificant to you.
If you believe a market is going up, you would buy a futures contract and at the same time buy a put option in the same month. If you believe a market is going down, you would sell a futures contract and then buy a call in the same month. By doing this you have taken some of the stress out of the trade. You now have a better grasp of what your risks are and you become less concerned if your timing is off by a little bit. You no longer have to worry if the market takes a quick spurt to your stop price, which would have knocked you out of your position. You now have more control over your risk from both a money and time perspective. I recommend that you might consider employing this strategy for longer-term trades of three months or more.
Please feel free to call me and discuss this strategy, or any others.
Michael Florez is a Senior Market Strategist with Lind Plus. He can be reached at 800-682-8325 for more information about this topic or others.
Kristina Zurla Landgraf is editor of LindForum. She can be reached at editor@lind-waldock.com.
Options strategies can involve a high degree of risk and may not be suitable for the novice investor. Buying an option involves a clearly defined risk; you pay for the premium and the commission and the worst that can happen is the option goes to zero and you lose your initial investment. When you sell an option, the option can potentially go against you an infinite amount and your losses can be severe. Please consult with a professional advisor before employing options strategies.
Futures trading involves substantial risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades, and any dollar amount quoted is exclusive of commissions and fees. All trading decisions will be made by the account holder.
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